From Contagion to Incoherence: Toward a model of the unfolding Eurozone Crisis

This post offers readers a fully-fledged analytical model of the unfolding Eurozone Crisis. It begins with a macro-economic analysis of the Crisis’ causes and then, importantly, models the feedback between Europe’s institutional and policy responses and the contagion process that began with Greece. For the fully-fledged (wonkish) version of the paper, click here. What follows below is a maths-free summary of each of the paper’s sections.

1. Introduction: Toward a macro-model of contagion

For three years now we have been discussing the Eurozone Crisis and the contagion dynamic that brought the Eurozone on the verge of disintegration. However, to my knowledge, no macroeconomic model of this process has been offered; at least not one that depicts the dynamic feedback mechanism between the Crisis and Europe’s responses (or lack thereof) to it. With this paper, I try to make amends and to offer a simple analysis of the nexus between:

  • (a) a monetary union whose very design removed internal shock absorbers while, at once, magnifying both the probability and the magnitude of a future crisis,
  • (b) a political response to the (preordained) crisis that involved the creation of toxic bailout funds which accentuated the crisis,
  • (c) the underlying macroeconomic imbalances which are in fact deepening, thus rendering the European Union’s fiscal and monetary strategies logically incoherent, and
  • (d) a European Central Bank whose decisive intervention to offer medium term financial stability (the LTRO and OMT re-financing programs for banks Italy-Spain respectively) came at the price of reinforcing long term disintegration.

2. Europe’s Gold Standard

Setting the scene, and before discussing the Crisis itself, Section 2 describes European Monetary Union as an interesting variant of the mid-war Gold Standard. Unlike other explanations of the Euro Crisis, which focus exclusively on a prior divergence of labour unit costs and competitiveness (between the surplus and the deficit member-states), the analysis here highlights the importance of the difference in degrees of oligopoly (or concentration) in advanced capital goods sectors across the surplus-deficit member-states’ divide.

My argument is that, given the deficit economies’ lack of high concentration of networked, globalising conglomerates (which can automatically convert capital inflows into productivity-enhancing investments), monetary union occasioned large capital flows (from the surplus to the deficit countries) which, in turn, caused rampant asset value inflation (e.g. real estate bubbles) in the deficit economies and a growth rate that far exceeded the rate of accumulation in their exportables’ sector. In contrast, the surplus economies (whose manufacturing is by definition more highly oligopolised) in fact lack competitors in the deficit nations (e.g. countries like Greece produce no cars) and, naturally, experienced simultaneously (a) high investment rates into productivity-enhancing capital and (b) a considerably lower concomitant growth rate.

This combination of growth rates that exceed (trail) fixed capital formation rates in the deficit (surplus) countries gave rise to a tension between:

  • the underlying economic reality of a slow burning recession in crucial sectors across the surplus-deficit nation divide, and
  • the epiphenomenal growth that seems to typify the whole common currency or fixed exchange rates bloc and is underpinned by a new form of financial exploitation of working and middle classes.

At some point, this tension ruptured under the strains of an imported financial crisis which soon ignited a classic debt-deflationary spiral with the burden of adjustment disproportionately placed on the shoulders of the weakest member-states. This is, indeed, what the world witnessed in the run up to, and after, the Crash of 1929 and it is precisely the same process that we witnessed in the Eurozone recently. It is as if the common currency’s designers chose purposely not to heed the lessons of the dreadful mid-war era that conspired to cause humanity’s greatest tragedy.

Section 2 then proceeds to discuss in some detail the differences between the Gold Standard and the Eurozone construction and to offer a mathematical analysis of the steady built-up of imbalances which set the Eurozone up for a mighty fall the moment the Credit Crunch of 2007 and the Crash of 2008 hit.

3. Greece and the toxic bailout funds EFSF-ESM

In its third section the paper discusses the significance of Greece: It begins with the observation that, in their attempt

  • to stop the bond markets from failing (once the Greek public sector had become insolvent),
  • to avert the prospect of a default by a member-state within the Eurozone, and
  • to preserve the principle of Perfectly Separable Debts upon which the Eurozone was founded,

Europe’s leaders came up with a complex loan structure. Thus, the largest credit line in human history was extended to bankrupt Greece by means of an odd loan made up of many bilateral ones (one between each of the other sixteen member states and Greece, one between the IMF and Greece and one between the ECB and Greece).

While the borrower, Greece, paid a single (exceptionally high, at least at the outset) interest rate to its European lenders (and a considerably lower one to the IMF), each of the member-states lending to Greece bore its own, separate interest rate in line with the yields of its own government bonds. So, when a few days after the Greek Bailout Mk1 was settled, Europe put together the EFSF (European Financial Stability Facility) in order, supposedly, to ring-fence the rest of the Eurozone’s susceptible sovereigns (i.e. Ireland and Portugal but also Italy and Spain), in a manner that incorporated the structure of the Greek loan. In short, the bonds that the EFSF was to issue reflected this patchwork of separate and separable loans, thus resembling CDO-like, toxic debt instruments.

Before the EFSF was established, the only institution that characterised the common currency area was the ECB; a central bank lacking a mandate to act as a lender of last resort (either for the Eurozone’s banks or for its sovereigns). So, when the credit crunch hit Europe, the scene was set for a sequential bankruptcy of pairs of sovereigns and banking systems. Remarkably, to prop up the collapsing edifice, Europe’s leadership erected around it the scaffolding of bailout funds (the EFSF-ESM) funded by toxic derivative-like bonds which contained the seed of faster contagion!

4. The EFSF-reinforced contagion

In concert with posts that have been appearing regularly on this blog in months and years past (e.g. see here and here), the fourth section of the paper explains precisely (and by means of a fully-fledged mathematical model) my claim that the toxic bonds issued by the new institutions were indeed of a toxic CDO-like nature and how their very structure gave the Crisis another twirl, ending up with the insolvency of Italy and Spain and, inevitably, with the twin interventions in 2012 of Mr Draghi, the President of the ECB.

5. The Fiscal Pact and the ECB’s ‘extraordinary’ (LTRO & OMT) programs

In addition to the toxicity of the EFSF-ESM bonds, which enabled (rather than impeding) the process of contagion, Europe did something else to deepen the Crisis: It introduced the highly contractionary Fiscal Pact in the midst of recessionary times, thus guaranteeing the unsustainability of the fiscal consolidation process. Indeed, the section demonstrates geometrically that the only way that the Eurozone could ‘pull off’ its fiscal plan under the prevailing conditions of large net private sector savings, was if it were to turn successfully into a mercantilist fiend – with both its surplus and deficit countries developing substantial current account surpluses with the rest of the world.

Importantly, Section 5 links the analysis of the EFSF-ESM’ toxicity (see Section 4) to the structural imbalances in the real sectors of the Eurozone’s macroeconomy as accentuated by the Fiscal Pact. It also offers a novel interpretation of the impact of Mr Draghi’s two main policy interventions, the LTRO and the OMT. In particular, it shows, by means of a simple phase diagram (underpinned by a system of two differential equations), how the ‘Draghi Effect’ calmed down the inter-bank and bond markets while ‘allowing’ the tectonic plates under that ‘surface’ to continue to work toward the disintegration of the Eurozone.

The section concludes, to put it succinctly, with the suggestion that never before in economic history has logical incoherence been given a constitutional expression (the Fiscal Pact) that reality is bound to wreck.

6 Conclusion

Here I present the paper’s conclusion in full:

The Eurozone was founded on two principles.

  • Principle 1:  That its central bank would be explicitly banned from acting as a lender of last resort (for states and/or banks facing insolvency).
  • Principle 2: The principle of Perfectly Separable Sovereign Debts.

Thus the scene was set for contagion following a financial crisis that could readily cause pairs of national banking systems and states sequentially to titter on the verge of bankruptcy. Europe’s reaction was to establish a new institution EFSF-ESM that would borrow on behalf of its (still) solvent member-states in order to prevent sovereign defaults. Alas, the structure of that ‘special purpose vehicle’ was such that, with its bonds redolent with the whiff of toxic derivatives, deeper and faster contagion followed. At some point, in a bid to prevent the European Monetary Union’s disintegration, the ECB stepped in. But to be allowed to step in (with its LTRO and OMT programs) the ECB first had to enter into a Faustian Bargain with the surplus countries: In exchange of being unshackled from the prohibition from acting as a lender of last resort, the ECB had to commit to using its coercive powers in order to impose the greatest austerity upon the weakest member-states. And thus the ECB-based ‘solution’ worsens the fundamental Eurozone’s macroeconomic conundrum so as to bring temporary stability to the inter-bank and bond markets.

This paper offered a simple analytical model of the above. Its conclusion is that, at this stage of the Eurozone Crisis, the ECB’s intervention has arrested contagion at the expense of greater macroeconomic incoherence. And since the latter always, inevitably, reinforces the former, all celebrations of the Crisis’ taming are likely to prove pure folly.


53 thoughts on “From Contagion to Incoherence: Toward a model of the unfolding Eurozone Crisis

    • During the second world war the Germans were putting in the gates of concentration camps “arbeit macht frei”. Now they put “arbeit macht frei to the whole country with government of Greece as capos.

    • Demetre – “Now they put “arbeit macht frei to the whole country with government of Greece as capos”. – Demetre you misidentify you enemy. You need to understand it is the Greek politicians putting the signs up not the German government. Either they are working for foreign entities instead of the Greek people or they have been taken hostage, either way they are illegitimate and cannot be trusted, they have been completely compromised.

  1. Yani I was shocked to hear (skai tv evangelatos today) that Greece is planning to borow from the market this summer.

    Switching from the EFSF/ESM to the OMT like Ireland?

    Greece being in this condition?

    It is crazy

  2. Yanis – To address a couple of the bullet points in your post

    “a monetary union whose very design removed internal shock absorbers while, at once, magnifying both the probability and the magnitude of a future crisis,” – The EZ insulated populations from state defaults. This has increased the protection of the people and their savings

    “the underlying macroeconomic imbalances which are in fact deepening, thus rendering the European Union’s fiscal and monetary strategies logically incoherent, ” – deepening due to the self destructive reactions of governments in trouble. ie imposing draconian tax increases.

    In short, looking at Greece, the ECB, Greek government and EU are solely responsible for destruction of the economy. They stopped a default, they increased taxes beyond recognition, they increased the debt burden. The problems in Greece have nothing to do with the Euro.

    • ” they increased taxes beyond recognition”

      The nominal taxes, maybe. If the Greeks would have paid the due taxes all the years, Greek wouldn’t be where it is now, and wouldn’t have needed to increase some of the taxes. In principle the same applies to Italy. Also there, tax evasion is a national sport. But how can any country sort of keeping the finances in order if the sovereign refuses to contribute his part?

    • VSS – “The nominal taxes, maybe.” – Your talking about something you have no idea about here. Let me tell you some of the taxes that are higher in terms of Euro, In Greece than the UK.

      Car Tax, Fuel Duty, Property Tax, VAT and for people earning less than 20K a year, Self Employed Social Security. With regards to actual tax rates that are higher in Greece, Income Tax, Social Security.

      All these taxes with the exception of Social Security and income tax have more than doubled since 2008. With regards to income tax, the less you earn the bigger the increase.

      Greeks are now paying more taxes in Euro terms than a Brit earning the same amount even though incomes are more than 30% less than in the UK. This is why the economy is imploding, it is not due to any fictional government cuts.

      “If the Greeks would have paid the due taxes all the years,” – Tell me you have something more than the words of a Greek politician. The crime rate in Greece is far lower than that of the UK or Germany. On what evidence are you basing your opinion on? It cannot be the criminal tendency of the population.

      “Greek wouldn’t be where it is now, and wouldn’t have needed to increase some of the taxes.” – Are suggesting that you believe the Greek population suddenly started behaving in a way that was impossible for the government to forecast? If so what behavior changed and when?

    • Tax evasion is a national sport everywhere. In Italy and Greece it is a Olympic discipline!

    • Pedro – Thats fine, but can you show me where you get your information? So I know where Greek politicians/people in general are getting their information from.

    • You just need to look into the numbers. Taxes collected by GDP in Greece are one of the lowest in Europe, even lower than Switzerland. If you look at the tax rates Greece is not one of the lowest, though not as high as all the Greeks complain… How do you get low tax revenues by GDP even when rates are not low? You evade.

    • Pedro – GDP figures mean nothing if the government is borrowing from outside massively as is the case with Greece. You would expect tax revenues to be low vs GDP. “You evade.” – Again, I ask you for your sources of information.

  3. The Hellenic drama

    (A poem written in English
    with Greek words)

    In agony
    to apologize

    In the hysteria
    of our prophetic epitaph

    The ecstasy
    of the economic ideology
    organizes the throne
    of misery

    But poetry always
    embarks to
    her lyrical rhythm
    without jealousy
    for her expatriation

    Yannis Politopoulos

    • Finally!
      Some points of their party platform (translated with google translate):

      monetary policy

      We call for an orderly resolution of the euro zone. Germany does not need the euro. Other countries hurts the euro.
      We call for the reintroduction of national currencies, or to create smaller and more stable currency unions. The reintroduction of the DM should not be taboo.
      We call for a change in the European treaties to allow each State leaving the euro. Each nation must decide democratically allowed its currency.
      We demand that Germany enforces this right of withdrawal from the euro by blocking further aid loans of ESM with his veto.
      We demand that the cost of the so-called bailout policy is not borne by taxpayers. Banks, hedge funds and large private investors are the beneficiaries of this policy. You first need to stand up straight.
      We demand that hopelessly over-indebted countries like Greece with debts of a debt restructuring. Banks must bear their own losses or are stabilized at the expense of its major private creditors.
      We demand an immediate ban on the purchase of scrap paper by the European Central Bank. Inflation should not erode the savings of citizens.

      policy on the European Union

      We call for a Europe of sovereign states with a common internal market. We want to live together in friendship and good neighborliness.
      We demand to leave the budget law to the national parliaments. A transfer union or even a centralized European state, we totally reject.
      We demand to shift legislative powers back to national parliaments. About bulbs and cucumbers curvatures can decide the Bundestag alone.
      We call for a reform of the EU to reduce the bureaucracy in Brussels and to promote transparency and openness.
      We demand to return the salaries of Brussels officials to size. It is shameful that Brussels officials earn thousands more than the Chancellor.
      The European Parliament has failed in controlling Brussels. We strongly support the positions of David Cameron, the EU streamline through more competition and personal responsibility.


      Please support such movements for a better Europe.

    • Hilarious, their manifesto of “policies”. May I add one more? that would be returning to the principles and modus operandi of the GDR, but without the pretence of being communist. They can rebuild the Berlin Wall, but slightly to the west of where it used to be.

    • You know some of the demands sound resonable…but then i read this:

      We demand an immediate ban on the purchase of scrap paper by the European Central Bank. Inflation should not erode the savings of citizens.

      And it gets ridiculous…..

    • @crossover: it’s modern German nationalism (quite different from Nazi). But the problem is that it is more or less based on the policies of Germany in the 1950s — low inflation, low employment rate (because women were not tolerated in the labour market), strong export market, and Gastarbeiter to do the low pay and dirty jobs. There is no recognition of global markets, EU free movement of capital, goods and labour and zero understanding of the euro crisis.

      It is basically mindless and uttered by morons who have no clue about what is going on in Europe or the world. It shows that Germany is not capable of leading Europe and should be removed from this absurd position. Of course, if they leave the EU then Germany will be back in the late 1940s — which is why I advocate following the model of East Germany. Let them suffer as the Greeks are suffering now.

    • “The introduction of the euro has proved to be a fatal mistake, that threatens the welfare of us all. The old parties are used up. They stubbornly refuse to admit their mistakes” as stated by the AfD is 100% correct. Question is, are the recipes the AfD proposes feasible and really the better way to go.

    • VSS – ““The introduction of the euro has proved to be a fatal mistake, that threatens the welfare of us all. The old parties are used up. They stubbornly refuse to admit their mistakes” as stated by the AfD is 100% correct. ”

      The *only* thing the Euro changed was the ability of national governments to inflate away their debts. Or to put in another way, the Euro took away the government’s ability to tax their people with inflation. Nothing else changed. Nothing. I cannot understand why you think this is a problem.

      The consequences we are seeing in Greece is the Greek government and their backers throwing a hissy fit and punishing the Greek people as a way to manipulate German economic policy so it adopts something like Yanis’s proposal of recycling.

    • Crossover – Your consistent “You know some of the demands sound resonable…but then i read this:

      We demand an immediate ban on the purchase of scrap paper by the European Central Bank. Inflation should not erode the savings of citizens.”

      Why exactly do you think people should not be able to save?

  4. As each day goes by, this is less and less an issue of economic crisis. Its a sociological crisis. Today I received a copy of Franco Berardi’s “The uprising” whereupon hes throughly discusses these issues with a social lens while discarding the financial lens because it’s already been shattered after this long experiment with neoliberalism.

    I think it’s important at this point to absolve oneself of pure economic thinking and realize that this is a crisis of competing ideas which have reduced the opportunity space of things to a single grid in which the future is already predetermined if one relied on the financializaiton motifs. The other choice is the way out, and that involves a complete reassessment of labor, politics, and business. In other words, an “uprising”.

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  8. Excellent piece of paper, even that i dont understand all those mathematical things.

    We all start to get enough of this terrible experiment… even Germany.

    Is it already time to start planing, how to start issue own currencies and hyperinflate euro to history? All it needs is, that some big countries leave from euro and start issuing their own currency, like Great Britain did back in Great depression, when it left from gold standard.

    I dont get, why we even went into this experiment, because ERM didnt work and when countries had to leave it, because their currencies were over valuated it made some huge profits for banksters, who knew, that currencies were over valuated and played against those currencies. There was no rational reason for euro, it was doomed from begging. Germany is way too strong for most of us.

    Countries just have to drop this currency and start issuing their own. Otherwise this bad dream will never end.

  9. Thank-you for this analysis. You continue a long tradition of Greek story-telling that has enlightened humanity for millenia.

    Yanis cities 2 papers by De Grauwe relevant to his excellent paper. Another recent and relevant paper by De Grauwe (Feb 2013) provides evidence of the importance of self-fulfilling debt panics created by banks, in countries that no longer have their own currencies, which some of you may not have seen.

    De Grauwe P, Ji Y. Panic-driven austerity in the Eurozone and its implications. Feb 21, 2013. Available at Vos Eu

    Analysis of De Grauwe papers in:
    Krugman P. Paul De Grauwe and the Rehn of Terror. New York Times. Feb 22. 2013. Available at:

    Keen S. An empirical nail for the austerity coffin. Business Spectator Feb 26, 2013. Available at:

    • in a nutshell its the “strategy of tension” all over again. I see Dario Fo back with Beppe’s big win. Franca Rame is also back,and now all we need to see is the reincarnation of Oriana Fallaci and then you know its the 60’s all over again.

  10. Are you able to speculate on motives? Following the US example, the Euro ought to be a contributor to prosperity: It should have made it easier for firms in Greece to have an outward or global perspective, larger markets, lower complexity in EU trade, price arbitration against local cartels, etc. I think that’s why the people accepted it, even though we knew it’s also pro-capital and big business.

    Why did it fail so badly? Is the failed construction simply the result of a cultural bias, let’s call it German-Austrian, that mixes a strict ideology of fiscal responsibility with faith in commodity (non-inflating, gold-like) money while lacking modern pragmatism? Is it much more short-sighted vested interest of banks or manufacturing sectors in surplus economies with no regard to systemic effects?

    I’d be sad to see the Euro go. It certainly looks like a good thing done really badly. You and others have enlightened its mechanical faults but I’m left wondering what ideological common ground remains, or not, for a new start.

    • Pavlos – “Why did it fail so badly” – This has been documented many times on this blog but let me repeat.

      The ECB monetised Greek government debt even though the ECB knew that there would be no way for the Greek government to service the debt.

      It is as simple as that.

      About motives? Again the motives are repeated time and time again by the mainstream media. Centralizing control of the Euro and the EU in general.

      There is no mystery.

  11. …..The “German dream” is a “European nightmare” the French newspaper Le Monde wrote in a vehement commentary last week. According to the newspaper, Germany doesn’t give a damn about the euro, is selfish, acts as if it has all the answers and has decreed that Italy and Greece shall be ruled by technocratic governments. After the election defeat of Mario Monti, such governments have no future, the commentary concludes….

    …..Chancellor Merkel is the “true loser of our election,” says Lucia Annunziata, editor in chief of the Italian edition of the Huffington Post, and one of the country’s most influential journalists. It is Wednesday, and she’s sitting in an editorial meeting and discussing the front-page headline for a piece on the clowns comment made by German Social Democratic Party (SPD) chancellor candidate Peer Steinbrück — and on Italian President Giorgio Napolitano’s response. The headline reads “Napolitano Saves Italy’s Honor.” Annunziata says that the Italians have “voted against the German crisis policy.”

    Indeed, what the Germans somewhat euphemistically refer to as “reform policy” translates throughout Southern Europe as cost-cutting, reducing and foregoing, concepts that have an ugly ring to them. While many German policymakers and economists assume that Italy, Greece and Spain will be able to emerge from the current crisis as strong and competitive nations after a few hard years, it is primarily Anglo-Saxon economic experts who are convinced of the opposite: They see the austerity policies as a vicious circle that is dragging these countries deeper and deeper into recession……

  12. We see the self same “mindset” here in the UK where today, all talk is about the debate between those government departments that wish to continue spending and their leading politicians seeking to reduce the welfare budget to pay for it. No one wants to talk about any other proposal; no one seems capable of admitting that the problem of welfare overspend is simply a symptom of lack of private sector job creation – in modern parlance; “Growth”.

    They have NEVER EVER created a private sector job; particularly a free enterprise one not under their complete control. The consequence being they have not the foggiest notion of how that simple process works. Rather than accept that they do not know how; they refuse to accept any such notion exists. The only jobs, (sorry, growth), they know how to create are government inspired, government funded, (Oh! Yes! I do understand that they will sometimes offer a 50% grant for the private sector), …….. but have no idea that the other 50% is completely non-existent and why so many of us refuse that Faustian bargain, which always removes the freedom of the individual and as such always creates non free enterprise growth.

    Individual freedom, “Individualism” is a pejorative expression of everything they hate about the external economy. So, rather than see the rest of the population free to do their own thing, outside of their direct control; they will stand back and watch the entire edifice collapse; locked in the deathly embrace of their own stupidity.

    We most often see bankruptcy as a monetary process; forgetting that monetary bankruptcy is a classic symptom of intellectual bankruptcy; where an organisation is bankrupt; simply because their leadership cannot contemplate a change of direction. In their panic, they become intellectually “Locked”, unable to change direction.

    All we can do is keep presenting a sane alternative.

    • Oh dear, more neo-Austrian, market-fascist goobledegook – “no, no, the problem with the 1980s and 1990s wasn’t that there was too much market freedom for monopolistic financial services zombies, it was that there was too little!”

      Haven’t you corporate shill boys and girls done enough damage?

    • Jon – Associating fascism with Austrian economic shows one of two things. Either you have not got a clue about Austrian economics, or you have no clue about fascism. I would bet on the former.

  13. “The Eurozone was founded on two principles […]”

    There were a few more, as stated in the Maastricht Treaties.

    Like, the participating nations keep their financial houses in order, there is no bail-out, no mutualization of debt and so on.

    All broken by now.

    • Yup as will the EUR! Because as soon as all the lies and broken promises will have an effect on the people, the will not trust the one size fits none currency anmore.

      Paper currencies are nothing without trust. The Euro will die pretty soon. The sooner, the better!

    • A anti EURO party won 10% from scratch in 2 Austrian state elections on the week end! hahahaha!

  14. This is a very strange moment to remember the difficulties of the Eurozone. The UK is sinking. They are completely free of the shackles of the euro. They have committed none of the follies of the ECB. Are we to blame Germany for the rise of the euro AND the fall of the pound AND the loss of the AAA ???%$#@!!! And is the path of the UK what Italy, Spain and Greece should follow?

    • Sweden? I thought you didn’t like socialism.
      Oh wait, you don’t think Sweden is much closer to socialism than Greece is….

  15. All they want is further integration, and they think they can achieve it through debt colonies. It is essential for a debt colony not to bankrupt (it wouldn’t be a debt colony then)

    But also the making of debt colonies using “sick” monetary unions (because of the stupidity the idea folds), provokes the money markets and the vulptures that understand the “gap”.
    In that sense i think that all the moves that have been done did not deal with the crisis itself, but to give EZ some credibility in the eyes of the markets and prevent the vulptures, but without abandoning the primary cause.

    There is no other way to explain why stupidity rules, and sane proposal like yours are abandoned.

    There is no other way to explain the Fiscal pact and the EFSF, OMT

    Excellent piece. Thanks again

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